Liquidity is a complicated-and oft-discussed-topic in ETFs. Many investors have rules about only investing in ETFs with a certain level of liquidity, by which they mean, only in ETFs with a certain average daily trading volume. That average volume can play an important role in how an ETF trades, including whether a fund trades with wide or narrow spreads.

The truth, however, is that the liquidity of the underlying markets that ETFs track is equally important. The lower the liquidity of the underlying, the higher the likelihood that a fund will trade with significant spreads and at significant premium or discount to its net asset value.

The deciding factor here is the efficiency of the fund's creation/redemption mechanism.

The creation/redemption mechanism is the process by which institutional investors, called authorized participants (APs), make and destroy ETF shares. The process allows APs to create new ETF shares at NAV when the ETF is trading at a premium, and redeem shares when it's trading at a discount. Both actions help drive the ETF's market price back in line with the NAV.

For ETFs tracking highly liquid markets, arbitrageurs can easily ferret out premiums and discounts before they become too large. Sometimes, though, inefficiencies in the creation/redemption process can arise-especially for ETFs tracking thinly traded or highly illiquid markets.

Consider the tumultuous premiums/discounts the iShares iBoxx High Yield Bond ETF (NYSE Arca: HYG) exhibited in the nine months leading up to June 30, 2009:

When the credit markets froze during September and October 2008, HYG jackknifed between premium and discount almost daily. During December 2008's bond run-up, HYG traded at a sustained 10% premium (or higher) for several weeks. Even now, HYG continues to trade at substantial premiums to NAV.

In HYG's case, poor liquidity in the underlying market weakened the efficacy of the creation/redemption process. As a high-yield bond instrument, HYG tracks a notoriously illiquid asset class, even under ideal market conditions. But during 2008's financial implosion, it became nearly impossible for APs to create or redeem shares and maintain low premiums and discounts on the fund.

A similar situation occurred after the United States Natural Gas Fund (NYSE Arca: UNG) halted its issuance of new creation units in early July, due to SEC holdups and regulatory uncertainty. As of mid-August, with still no new creations, UNG regularly traded at premiums above 5%.

As 2008 showed, an ETF's underlying liquidity plummets when it tracks highly illiquid and thinly traded markets. The availability of underlying securities shrinks and/or trading costs become unfeasibly high, discouraging arbitrageurs from creating or redeeming ETF shares.

When creation/redemption fails to function properly, ETFs start behaving more like closed-ended funds, trading at a premium when the majority of investors are buying and at a discount when most investors are selling.

It's a risk in all ETFs. But keeping an eye on the liquidity of the underlying will let you know just how big a risk it is.